We explore how tax evasion by firms affects the growth- and welfare-maximizing rates of corporate income tax (CIT) in an endogenous growth model with productive public service. We show that the negative effect of CIT on growth is mitigated in the presence of tax evasion. This increases the benefit of raising the CIT rate for public service provision. Thus, in contrast to Barro [(1990) Journal of Political Economy 98, 103–125], the optimal tax rate is higher than the output elasticity of public service. Through numerical exercises, we demonstrate that the role of tax evasion by firms is quantitatively significant.
